Musings on economics and politics, with a special interest in free banking and monetary disequilibrium.

Sunday, September 1, 2013

Selgin on Market Monetarism

George Selgin takes Market Monetarists to task for discounting the problem of booms. He recognizes that Scott Sumner and other Market Monetarists advocate a nominal GDP level target that is symmetrical. If nominal GDP should rise above the target growth path, the monetary regime should reverse the upward deviation.

So what is the problem? It is the skepticism among Market Monetarists that such an upward deviation in nominal GDP makes anything worth describing as a recession inevitable. In particular, nominal GDP can be returned to its prior growth path. There is absolutely no need for spending on output to fall below that growth path, much less drop to the level that existed before the upward deviation.

For example, suppose the target growth path for nominal GDP has a 3% growth rate. Unfortunately, there is a 2% upward deviation resulting in a 5% growth rate. Level targeting requires that the growth rate be approximately 1% the next year, so that it is now 6% greater than its level before the excessive spending growth two years before. There was no decrease in nominal GDP at all. Market Monetarists would insist that it is not necessary or desirable for nominal GDP to fall 5%, or even 2%, in the second year.

While Market Monetarists favor a target growth path, few of us would argue that growth rate targeting is unfeasible. In other words, it would be possible for nominal GDP to grow 5% one year, and then return to growing 3% in the future. The extra large upward deviation could be allowed to shift the economy up to a permanently higher growth path for nominal GDP. Not only would there be no decrease in nominal GDP, there would be no future slow down to return to the previous growth path.

What about real output? Recessions are not usually defined in terms of spending on output, but rather in terms of the growth rate of real output. Recessions are usually defined as a negative growth rate. Now, suppose potential output, the productive capacity of the economy is growing 3% and production is at capacity. Nominal GDP is on its target growth path, and the price level is stable. Then, suppose nominal GDP grows 5% and that the more rapid than usual increase in sales motivates firms to expand production more than usual. Rather than expanding their output by the usual 3%, they expand production 4%. The following year, the growth rate of nominal GDP is 1%. Nominal GDP returns to its initial growth path.

Is it necessary that real output fall 4%, reversing the expansion during the boom? Or even that it fall1%, reversing the excess growth? Or is it possible that real output might rise 2%, and return to its previous growth path? That is, like nominal GDP, it would 6% higher than it was two years before, exactly in line with the growth path of potential output.

One possible scenario is that during the year with nominal GDP growing 5%, the price level rises 1%. And then, in the following year, when nominal GDP grew only 1%, the price level falls by 1%, returning to its initial level, as real output rose 2%. At no point would real output fall. It would just grow each and every year, and grow extra fast, 4%, in one year, and a bit slower, 2%, the next year, so that over the entire period, it grows 6%, exactly in line with potential output.

While recessions are usually defined in terms of the growth rate of real output, an alternative approach is to consider the output gap--real output minus potential output. The phenomenon of concern is production below capacity, regardless of whether production is rising or falling. In the scenario above, the more rapid growth of nominal GDP results in real output rising above potential. And then in the next period, it returns to potential. The increase in real output above potential the first year does not require that it fall below potential the following year.

Of course, the notion that real output can rise above potential is a bit of a puzzle. How is it possible to produce more than there is the capacity to produce? Selgin suggests that Market Monetarists follow Milton Friedman in having a "plucking" model. When nominal GDP grows shifts down to a lower growth path, this causes real output to fall below potential. And then, as inflation slows and the price level adjusts to a lower growth path, or nominal GDP recovers, real output returns to potential. While real output falls below potential, on this view, it never rises above potential.

If potential output is assumed to stay on a 3% growth path, this would be a bit implausible. But once it is recognized that potential output almost certainly sometimes grows faster and other times more slowly, then booms can be explained as periods where potential output is above trend. Recessions then can either be potential output growing below trend or else real output falling below potential. It seems reasonable to me that mild "growth recessions" could either be due to a slow down in the growth of spending on output or a slow down in the growth of potential output. Deep recessions, on the other hand, would be due to decreases in spending on output.

Still, I believe that real output can rise above potential, a view,which is shared by at least some other Market Monetarists. With imperfect competition, firms have excess capacity in equilibrium and so can expand output. If their prices are pre-set and there is an unexpected increase in demand, they will find in profitable to expand production. And then, when they reset prices or demand decreases, they will return production to its initial level. If potential output is growing, then it is possible to see real output rise more quickly when spending on output grows more quickly, and then grow more slowly as spending on output grows more slowly.

Sumner emphasizes sticky wages, and it would seem that something similar is likely. When demand grows more rapidly, firms with excess capital capacity use more labor and other variable inputs and produce and sell more output. If the situation persisted, then they will adjust the wages they pay, causing this effect to dissipate. How long does it take firms to recognizes that a higher growth path or rate of spending on output is going to persist and then respond by changing their labor compensation programs? Of course, with nominal GDP level targeting, there is no need to make these adjustments in compensation programs. When spending on output grows more slowly, the production and employment return to the previous growth paths.

The puzzling implication of this reasoning is that booms can be caused by more rapid spending growth, and they are times of enhanced production, employment, and human welfare. It is just that changing the growth rate or path of spending on output to create a perpetual boom is impossible.

Anyway, the puzzle of the boom, with output rising beyond potential has no counterpart in the recession. There is no technical problem with producing far below capacity. It is only that this implies surpluses of products and labor and the result should be lower prices and wages. The lower prices and wages increases real money balances and real expenditures on output. Assuming firms respond to growing sales by producing more, then production will rise back up to capacity. If prices and wages only adjust sluggishly and if the needed adjustment in prices and wages is large, then output can remain below capacity for a substantial period of time.

What happens if prices and wages are also sticky on the upside? In the scenario above, spending grew 5% and production rose 4% and prices 1%. Instead of the usual expansion of production by 3%, it was 1% higher and instead of the usual stable price level, there was 1% inflation. What if prices instead did not increase at all and it was impossible to expand production by more than 4%? Then there are shortages.

Now, shortages are not harmless. The story told in principles classes these days is that markets clear due to queuing costs. Those who have low opportunity costs of standing in line, obtain the goods and others do without. However, with a temporary upward deviation of spending on output, shortages are likely to show up as depletion of inventories and later delivery dates. There may be queuing for services too. Consumer goods and services don't go to those who value them most according to their willingness to pay. Perhaps of more concern, capital goods don't go to firms who can use them most productively.

If spending on output was allowed to shift to a higher growth path, then these inefficiencies of shortages would only dissipate as prices and wages adjusted upwards. If nominal GDP returned to its previous growth path, then any shortages would disappear, largely as growing productive capacity caught up with the level of spending. The increase in spending above was 5%, which is 2% greater than the increase in capacity. But the next year, capacity grows 3% as usual, which catches up with that 2% excess growth in spending, and then some. Spending on output grows 1% more to match.

Anyway, the short answer to Selgin is that scarcity puts a limit on how much extra real output can be produced in a "boom" while putting no constraint on the negative impact of a recession on production and employment. But as Selgin recognizes, Market Monetarists do favor keeping nominal GDP on the target growth path. Just because upward deviations of nominal GDP from target are unlikely to cause significant increases in real output doesn't mean that such deviations are desirable.

1 comment:

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